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Taxes on Tipped Employees

Hello, I'm looking for some direction on calculating checks that involve tips that are not paid on the check. The IRS says this in tax topic 761 regarding the order to do the calculation:
1.Social security and Medicare taxes on the employee's wages,
2.Federal income taxes on the employee's wages,
3.State and local taxes imposed on the employee's wages,
4.Social security and Medicare taxes on the employee's reported tips, and
5.Federal income taxes on the employee's reported tips

My question is, where do you calculate the state and local taxes on the EE's reported tips? Should it be done in step 3? Or is the IRS missing step 6?


  • I am not entirely sure I understand the sort of answer you are looking for. Almost everyone uses some sort of payroll system. Some have features which handle tips. With older systems you enter offsetting earnings/deductions. This will cause the taxes to calculate correctly.

  • Hi David, I'm looking for how one would do the calculation manually. Basically, I want to know at what point should you calculate the state and local taxes on the tips when there won't be enough earnings to cover all the taxes that should be deducted, and in what order those taxes should be reduced.

  • No one-size-fits-all answer. You sot of need to check the rules for each state. Generally speaking FIT/SIT comes last, FICA comes first, and other state/local taxes come somewhere in the middle.

  • Depends on whether the individual states and localities require withholding for income tax on employee reported tips. I would say, based on the order related to tax on employee wages, if the states and localities impose withholding on employee tips, it would be after federal income tax was imposed on the reported tips. That is, It looks like the IRS does not care about state and local taxes on reported tips - but federal taxes on employee reported tips cannot take priority over state and local tax on employee wages (step 3).

    Patriot software indicates that the IRS did indeed leave off step 6

    Personally, I would have thought that state and local income taxes would be on a par with federal income tax and the funds available would have to be allocated among the IRS, states, and localities - but that does not seem to be the case at steps 2 and 3 and is not likely to be the case at step 5 (and then 6 if there is still money left over after the IRS gets what it is supposed to get).

  • The harder you look at this, the stranger it gets. There is no clean, simple answer because the states do not agree with each other and withholding orders can get VERY complicated. I have always just used the CA rules, and put it on my "declared risk" list. The auditors did not like it but they were unable to answer the questions themselves. And this was a big-4 audit company. I was fortunate enough to work with bosses who had worked in the real world and not just audit companies.

    There is always a cost to remaining 100% compliant. (How many of you schedule extra payrolls for hand checks? Yes, there is a 2% rule for deposits, but you better very clear what your total hand checks issued and not deposited are).

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